The Court of Appeal has given guidance on when the duty of directors to have regard to the interest of creditors arises. This is an important point, as the general statutory duty of a director to promote the success of the company for the benefit of the company's members is expressly subject to the rules on creditors' interests. The court's decision also considers whether a dividend payment can be challenged as a transaction at an undervalue under section 423 of the Insolvency Act 1986.

Facts

The case involved a challenge to dividends paid by a company to its parent in December 2008 and May 2009. The background facts were complex, but essentially the dividends were paid at a time when the company had ceased to trade and, though it had various assets, was subject to contingent indemnity liabilities in respect of clean-up costs and damages claims arising out of historic environmental pollution.

The directors of the company, having regard to the company's assets and liabilities, including the contingent indemnity liabilities, as shown by its relevant accounts, concluded that the company had sufficient distributable reserves to declare a dividend. They declared the dividend in December 2008 and payment was effected by way of set-off against an equivalent amount of an intra-group receivable due to the company from its parent. Subsequently, to prepare the company for sale, a second dividend was declared in May 2009, and there was a further set-off.

The claimants, who had the benefit of the environmental indemnities, brought a claim in the High Court challenging the payment of the dividends on three grounds.

The "could not pay" claim: Part 23 of the Companies Act 2006 regulates the payment of dividends by a company, in particular providing that they may only be paid out of distributable profits available for the purpose as shown by the relevant accounts. The claimants argued that the dividends contravened Part 23 of the Companies Act 2006 as the accounts upon which the directors relied as showing there were sufficient distributable reserves to justify the payment of the dividends were incorrect and did not give a true and fair picture of the state of the company's finances.

The "should not pay" claim: The statutory duty of a director to promote the success of a company set out in section 172 of the Companies Act 2006 for the benefit of its members as a whole is explicitly made subject to any rule of law requiring directors in certain circumstances to consider or act in the interests of creditors of the company. The claimants argued that the dividends were paid in breach of the duty of the company's directors to have regard to the interests of its creditors.

The transaction at an undervalue claim: Under section 423 of the Insolvency Act 1986 a transaction can be set aside if it is a transaction at an undervalue and is entered for the purpose of putting assets beyond the reach of creditors or potential creditors, or is otherwise intended to prejudice their interests. The claimants argued that a dividend is a transaction for the purposes of section 423 and that the dividends paid by the company fell within the scope of the section.

The High Court dismissed all of the claimants' "could not pay" and "should not pay" claims, but found that a dividend is capable of falling within the scope of section 423 and that the May 2009 dividend (but not the December 2008 dividend) did fall within the scope of the section.

The claimants did not appeal the "could not pay" claim, but did appeal the "should not pay" claim in relation to the May 2009 dividend. The parent company appealed against the decision in relation to section 423 and the May 2009 dividend.

The "should not pay" claim: Delivering the leading judgment, David Richards LJ observed that previous cases suggested that there were at least four possible answers to the question of when the creditors' interests duty is triggered.

  • Alternative 1 - when the company is actually insolvent (on a cash flow or balance sheet basis).
  • Alternative 2 - when the company is on the verge of insolvency or nearing or approaching insolvency.
  • Alternative 3 - when the company is or is likely to become insolvent.
  • Alternative 4 - when there is a real, as opposed to a remote, risk of insolvency (the threshold argued by the claimants).

Having reviewed the authorities, David Richards LJ concluded that the formulation that accurately encapsulates when the duty arises is when the directors know or should know that the company is or is likely to become insolvent (alternative 3). In this context, "likely" means probable.

In reaching this conclusion, he noted problems with the other formulations as follows.

  • Alternative 1 – is too narrow, as the duty may arise short of actual insolvency.
  • Alternative 2 - suggests a temporal test, i.e. that actual insolvency will be established within a very short time. While this may well describe many situations in which the duty is triggered, it may not cover the situation where, although the company may be able to pay its debts as they fall due for some time, perhaps a considerable time, to come, insolvency is nonetheless likely to occur and decisions taken now may prejudice creditors when the likely insolvency occurs.
  • Alternative 4 – represents a significantly lower threshold than being either on the verge of insolvency or likely to become insolvent and goes beyond the present law as regards the creditors' interests duty.

As the company was not insolvent or likely to become insolvent at the time of the May dividend, the Court of Appeal upheld the High Court decision that paying the May 2009 dividend was not a breach of the directors' duty to have regard to creditors' interests.

The transaction at an undervalue claim:Under section 423(1) of the Insolvency Act 1986 a person enters a transaction at an undervalue with another person "if he makes a gift to the other person or otherwise enters into a transaction with the other on terms that provide for him to receive no consideration". A transaction includes a gift, agreement or arrangement.

David Richards LJ confirmed that the payment of a dividend is within the scope of section 423(1) as it is:

  • capable of coming within the definition of a "transaction", even if it is not a gift, agreement or arrangement (though, on the facts of this case, the May 2009 dividend did form part of an arrangement between the company and its shareholder); and
  • a transaction on terms that provide for the recipient to receive no consideration.

Further, he confirmed that the statutory purpose set out in section 423(3) of the Insolvency Act 1986 - i.e. whether the transaction is entered for the purpose of putting assets beyond the reach of creditors or potential creditors, or is otherwise intended to prejudice their interests - is a question of the subjective intention of the party entering the transaction. What did they aim to achieve? The statutory purpose does not have to be the sole or dominant purpose and it is sufficient if it can properly be described as a purpose and not merely as a consequence. On the facts, David Richards LJ found that the statutory purpose had been satisfied in relation to the May 2009 dividend and therefore upheld the High Court decision in relation to the transaction at an undervalue claim.

As regards the creditors' interest duty, the decision provides useful clarification as to when the section 172 duty of directors to promote the success of the company for the benefit of its members as a whole becomes subject to the creditors' interest duty. Although the case clarifies the principle that this is when the directors know or should know that the company is or is likely to (i.e. probably will) become insolvent, the application of the principle will always of course be fact-specific and directors will have to consider all relevant facts and circumstances. A further uncertainty is whether, once the creditors' interests duty is engaged, their interests are paramount or are to be considered without being decisive. This point did not arise on the facts and David Richards LJ expressly left it open, although he did comment that where the directors know or ought to know that the company is presently and actually insolvent, it is hard to see that creditors' interests could be anything but paramount.

In relation to dividends, directors should be aware that a distribution paid in accordance with the requirements of the Companies Act 2006 is capable of being challenged under section 423 of the Insolvency Act 1986, if it is made for the purpose of putting assets beyond the reach of creditors or potential creditors of a company.